Hennessee Hedge Fund Index declines -2.99% in May, 1.57% YTD

Hennessee Group LLC, an adviser to hedge fund investors, announced today that the Hennessee Hedge Fund Index declined -2.99% in May (+1.57% YTD), while the S&P 500 decreased -8.20% (-2.30% YTD), the Dow Jones Industrial Average declined -7.92% (-2.79%), and the NASDAQ Composite Index fell -8.29% (-0.53% YTD). Bonds advanced, as the Barclays Aggregate Bond Index increased +0.84% (+3.74% YTD), due to increases in U.S. Treasuries as both Investment Grade and High Yield bonds declined.

“May was the worst month of the year for hedge funds and the worst monthly drawdown since October 2008. However, hedge fund managers avoided significant losses and outperformed traditional benchmarks on a relative basis due to conservative exposures, hedging and short positions,” commented Charles Gradante, Co-Founder of Hennessee Group. “In May, we saw investors significantly de-risk portfolios as volatility increased. Given the negative headwinds that exist and potential global crises, hedge funds continue to operate with low gross exposure levels as they navigate an increasingly challenging investment environment.”

“Hedge funds’ defensive positioning prior to May helped limit losses and provided downside protection,” said Lee Hennessee, Managing Principal of Hennessee Group. “Downside protection is the primary benefit of the hedge fund asset class. In the current environment, where investors seem to be very skittish due to higher volatility and dramatic drawdowns, downside protection and hedges are extremely beneficial. We are seeing hedge funds garner continued interest by the investment community desiring lower drawdowns.”

The Hennessee Long/Short Equity Index declined -2.81% in May (+1.66% YTD). The equity market “flash crash”, the downgrade of European debt ratings, the Gulf oil spill, and the escalating tensions in Korea, spooked investors and triggered a flight to quality, namely U.S. Treasuries. The equity markets experienced a sharp, broad based sell-off, giving back all of 2010 gains and leaving most indices in the red for the year. All ten S&P sectors were in the red, led down by the energy sector (-11.8%) as the BP oil spill put heavy downward pressure on energy stocks.

Managers also lost money in the financial sector, as worries about European sovereign debt hammered financial services stocks. While hedge funds struggled to generate positive returns for investors given the broad based sell-off during the month, they still managed to outperform the broader indices on relative basis by a significant margin. Managers who were quick to trim exposures at the first sign of volatility fared better, with some funds able to squeeze out modest positive gains. In light of the ongoing macro issues and heightened volatility, hedge funds continue to reduce risk and remain cautious. The emphasis among hedge funds remains high quality, non-cyclical, defensive companies with low valuations, strong earnings growth and capital flexibility.

“I would be hard pressed not to mention the May 6th ‘Flash Crash’. While there have been several rumors about what caused it, an official explanation has yet to be announced,” commented Charles Gradante. “However, it is clear that there was a problem, likely due to high frequency or computer-programmed trading, as several fundamentally sound stocks approached unreasonable price levels. Panic and fear prevailed and liquidity disappeared. The regulatory authorities will no doubt investigate and resolve the problems to ensure they do not happen again. Hopefully, the installation of stock level circuit breakers will accomplish this. On a bright note, many hedge funds grew cautious at the beginning of second quarter and used the low volatility to establish protection against tail-risk events.”

The Hennessee Arbitrage/Event Driven Index declined –2.62% in May (+3.71% YTD). As the equity and credit markets declined in May, arbitrage strategies also fell, brought down by event driven, distressed, credit and convertible arbitrage strategies. Credit spreads widened due to concerns about the European government’s sovereign debt issues, with the spread on the Merrill Lynch High Yield Index widening from 561 basis points to 598 basis points during the month, after hitting a high of 724 basis points mid-month. The Merrill Lynch High Yield Master II Index fell -3.52% (+3.39% YTD).

The Hennessee Distressed Index declined –4.87% in May (+4.85% YTD). Distressed funds suffered losses due to declines in the equity and credit markets and the overall flight to quality. Due to their traditional net long bias, distressed funds typically experience losses in a downturn if there is a lack of specific catalysts. Despite the downturn in May, managers are still seeing ample long and short opportunities in distressed situations and dislocated assets. Managers are active in acquiring assets from banks and other lenders that continue to sell off assets in order to clean up balance sheets. The Hennessee Merger Arbitrage Index also declined, -1.04% in May (+1.29% YTD). Spreads widened due to an increase in volatility and the market decline. Managers are also optimistic for M&A due to the fact that companies have record amounts of cash on their balance sheets.

The Hennessee Convertible Arbitrage Index declined -3.00% (+2.08% YTD) in April. Wider spreads and secondary market cheapening detracted from performance, while volatility and interest rates made positive contributions. Managers report that the convertible space faced downward pressure due to dumping of convertible positions by European holders. A number of accounts lost money on currency hedges due to the fall in the euro, and were facing erosion of their equity and the fear or reality of investor redemptions. Managers also optimistically state that the convertible space is not as vulnerable as it was in 2008 because there is less leverage being employed, less paper in vulnerable holders, and steady participation by crossover buyers.

“I cannot remember when there have been so many potential ‘global crises’ happening at the same time,” commented Charles Gradante. “We have the oil spill in the Gulf of Mexico, the downgrades of the European PIIGS, altercations in the Middle East and Korean Peninsula, and concerns about Chinese monetary policy. In addition, domestically, we are facing greater uncertainty regarding regulation of markets, massive U.S. government debt, significantly higher taxes and the withdrawal of Federal stimulus. There are many things keeping hedge fund managers awake at night, and as a result, managers are operating with lower gross exposure levels.”

The Hennessee Global/Macro Index fell -3.50% in May (-0.65% YTD). International equities declined significantly as the MSCI EAFE Index fell -12.06% (-13.72% YTD) during the month. Global indices declined due to continued concern over the Eurozone, despite a 110 billion euro bailout from the area and additional stated support from the IMF. In the emerging markets, uncertainty over policy tightening in China and the prospect of conflict in Korea hurt performance in the emerging markets. Hedge funds benefited from reduced international exposure and defensive positioning, as the Hennessee International Index fell -4.02% (+0.38% YTD).

The Hennessee Macro Index was fell -0.79% for the month (+1.22% YTD). Gold was one of the few positive performers for the month, as investors remain concerned over currency instability and inflation in emerging markets. Managers lost money on short Treasury bets, which has been a consensus theme for some time. The 2-year Treasury yield fell from 1.10% to 0.75%, the 10-year Treasury yield fell from 3.66% to 3.31%, and the 30-year Treasury yield dropped from 4.53% to 4.23%. Some managers have been forced to cover this trade as it appears that rates may remain low for longer than anticipated. Managers experienced losses on currency trades, as many were forced to finally cover short dollar bets. Several managers, who lost money in commodities, used the sell off to add to core positions at attractive entry points.

Hennessee Group LLC is a Registered Investment Adviser that consults direct investors in hedge funds on asset allocation, manager selection, and ongoing monitoring of hedge fund managers. Hennessee Group LLC is not a tracker of hedge funds. www.hennesseegroup.com